Target the Forecast!

The Federal Reserve's backward-looking monetary policy led to huge mistakes last summer and fall, turning a mild recession into a major downturn. They seem unable to fight today's problems due to a fear of "long and variable lags". Solution: target the forecast.

Economic growth is widely expected to be below target -- so the Federal Reserve should take action to boost spending, which will then reduce unemployment.

The demand for money exceeds the supply, so money is tight. (Interest rates are in many ways a lagging indicator.) Much of the increase in the monetary base has gone to excess bank reserves, due in part to the Fed's highly contractionary policy of paying interest on those reserves.

One of the most useful indications of the market's expectations: the yield spread between conventional bonds and inflation-indexed bonds (e.g. TIPS). Right now the spreads indicate inflation is expected to be below 2% -- and there seems to be near universal agreement that GDP growth will be well below 5%.

Most economists agree that monetary policy can still be very effective even when the interest rate hits zero. It should use available tools to meet the demand for money. Fight today's battle today, and save the anti-inflation tools for the future. By targeting the forecast, the Fed has plenty of time (and sufficient tools) to nip inflation in the bud once unemployment is back down.

(Updated Aug. 2, 2009)

Here's some advice for The Fed

1. Announce a target of 5% annual NGDP growth.

(Or, as a second best approach, 2-3% inflation.)

2. Target the forecast, including market expectations.

(This avoids the dreaded "long and variable lags".)

3. Do whatever it takes to meet the target.

(Regain credibility.)

4. Stop paying interest on excess reserves.

(They are highly contractionary.)

If necessary:

5. Charge a small interest penalty on excess reserves.

6. Begin aggressive quantitative easing (QE).

Buy T-bills, notes, bonds and/or agency debt.

NGDP = Nominal GDP (real GDP plus inflation).

References

Primary source: TheMoneyIllusion blog by Prof. Scott Sumner. The key ideas are his, but the bullet points are my summary and paraphrase -- so don't blame him if I got something wrong.

Federal Reserve Chairman Bernanke has long been an advocate of an explicit inflation target, though others on the FOMC (Federal Open Market Committee) are opposed. It's also not clear whether Bernanke's views have changed in the past year.

Milton Friedman generally advocated a steady, automatic increase in the money supply but also wrote that "[keeping the] difference between a nominal and an indexed bond yield below some number ... seems to me to have real advantages over the nominal money supply".

Prof. Sumner's Blog

The FAQ is a good place to start. Here are some highlights from his blog (in order posted):